Joseph Krist

Publisher

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DETROIT AND A NO SPREAD MARKET

It was in 2014 that Detroit managed to work its way out of bankruptcy with limited tax bondholders recovering 34 cents on the dollar and unlimited tax holders 74 cents. This week the City was in the  market with general obligation debt. The City sold $135 million stand-alone, tax-exempt general obligation bonds with maturities out to 2050. The bonds came at  spreads of 100 bps to 128 bps to the Municipal Market Data’s AAA benchmark. Taxable bonds came at spreads of up to 250 basis points to Treasuries.

So have things improved greatly in terms of the city’s financial position and management? They certainly have but the city still faces daunting obstacles in its path to economic stability. The purpose of the bond issue itself is evidence of the city’s problems. In November, more than 70% of voters authorized $250 million of GO borrowing to finance blight removal. Proceeds will help finance the city’s renovation of 8,000 vacant homes and demolition of another 8,000. Those are some of the factors holding the city’s GO rating at BB-.

The driving factor enabling the city to achieve a fairly effective cost of borrowing is the continuing flow of money into municipal bond funds. In effect, too much money is chasing too few bonds. The pandemic and the need to keep interest rates low as a result of it have created a very favorable environment for borrowers whether it be new money in the case of Detroit or de facto restructurings. For those borrowers whose financial positions have been clearly impacted by the pandemic – especially those sectors dependent upon travel or entertainment – the current rate environment and supply and demand patterns encourage more borrowing.

KROLL REJECTS ESG SCORES

We were heartened to see Kroll Bond Rating Agency take a position on the issue of how environmental, social, and governance factors (ESG) should be addressed as part of the credit rating process. There is increasingly pressure on the rating agencies to develop methodologies which investors and fund managers and marketers can use to address the increasing investor emphasis on ESG. This interest has led to various efforts to develop distinct ESG scoring methodologies by a variety of entities with varying degrees of success (or the lack thereof). One of the criticisms of the effort, stems from that fact that many of the characteristics evaluated for purposes of ESG scoring do not necessarily lend themselves to a quantitative judgment.

Kroll’s view is that solid credit analysis has always taken ESG factors into account when developing a rating. “KBRA believes that ESG risks and opportunities are best analyzed through a lens of how well these risks are being identified and managed by issuers and/or by their transactions.” It you think about it, with municipalities being on the front line of both the impacts of natural disasters and the response to them, one could argue that the municipal market has been an ESG market for all its history.

Municipal bonds have always been unique in that “management” in the public sector has always been dependent upon the political process. Anyone who thinks that the market has not been making decisions for decades based on what are now grouped as ESG factors, just does not understand what the municipal market finances.

We don’t need a separate scoring system for evaluating things like the ESG value of clean air and water, reliable available public transportation, pollution control equipment, schools and recreational facilities. The social and environmental benefits of those investments is pretty clear. As for the governance aspect, so long as elected officials are the officers of municipalities, governance will be an imperfect process.

NJ MOVES TOWARDS BETTER CLIMATE RISK DISCLOSURE

The State of New Jersey has enacted a new law which would require municipalities to identify critical facilities such as roads and utilities that might be affected by hurricanes or sea-level rise; make plans to sustain normal life in the face of anticipated natural hazards, and integrate climate vulnerability with existing plans such as emergency management or flood-hazard strategies. Municipalities must “rely on the most recent natural hazard projections and best available science provided by the New Jersey Department of Environmental Protection” when they update master plans every 10 years, as required.

Seas at the Jersey Shore are expected to rise by up to 2.1 feet by 2050 and by as much as 6.3 feet by the end of the century, compared with the 2000 level, according to the latest forecast from Rutgers and the DEP. Nevertheless, as is always the case, the municipality’s lobbyists are planning to try to overturn the law under New Jersey law regarding state mandates.

So here is a challenge for all ESG investors. The municipalities balking at the new requirements would likely change their minds if they lost market access over climate issues. The Office of Legislative Services concluded in an analysis of the bill last September that its measures would result in just a “marginal” spending increase at municipal and state levels. You do not need a rating agency or really any other entity to tell you that the refusal to deal with climate change is a major credit impact. It is just common sense.

TRANSMISSION BOTTLENECKS THREATEN NEW GENERATION

One of the issues facing the utility industry is how it will accommodate the needs of alternative energy producers to be able to deliver their power to the transmission grid. It is becoming more of an issue as the renewable energy industry grows in tandem with increasing regulation driving producers away from fossil fuel usage. Recently, a couple of situations have arisen highlighting the issue and causing debate.

In Maine, the state’s investor owned utility Central Maine Power (CMP) is under fire for its “mismanagement” of the absorption of renewable energy from independent producers. Recently, CMP notified the developers of renewable energy resources that it had incorrectly estimated the cost for these producers to access the transmission grid operated  by CMP. CMP informed solar developers that its initial statements about how much it would cost solar projects to connect to the energy grid – costs that solar developers had already relied on for business investments in the millions – were incorrect and that an undisclosed number of projects would need to pay hundreds of thousands, if not millions, of dollars more in order to connect to CMP’s transmission system.

CMP has active requests for 2,000 megawatts of capacity in small renewable projects, known collectively as distributed generation. But the current grid is designed to handle a peak load of only 1,700 megawatts. Now, CMP is sending notices to solar power producers with whom it has signed and executed agreements to distribute their power that the costs determined by system impact studies were incorrect.

Typically, interconnection agreements were entered into after a system impact study evaluated whether a transmission utility’s substation and local distribution network can safely and reliably handle the new power. Projects don not move forward until those costs are established. The price rise from CMP could damage the economics of some projects such that they are not longer viable to operate. A survey sent last week to members of the Maine Renewable Energy Association found that more than 100 solar projects in 74 communities have received revised cost estimates from CMP totaling tens of millions of dollars.

The issue moves forward as it highlights policy making conflicts between state and local governments. CMP is making its moves while three Maine solar energy projects will receive a total of $17.6 million in federal loan guarantees from the Rural Energy for America Program operated by the U.S. Department of Agriculture’s Rural Development office. The projects each have interconnection and net energy billing agreements with Central Maine Power. 

As the week went on, the political reaction emerged and put significant pressure including the potential for a state investigation of CMP’s solar hook up practices. Lo and behold, CMP announced that it had found faster and less costly solutions that will allow more large solar projects to hook up to its electric distribution network. “CMP believes lower-cost upgrades, or the complete elimination of upgrades, may be possible with further study. Specifically, where initial estimates were $10-$15 million per substation reflecting a complete rebuild of the substation, estimates for all but a limited number of substations are now in the range of $175,000 to $375,000 for those substations that will require upgrades.”

So far, the problem seems to be one for the investor owned utilities to deal with. While cost is an issue for all for all utilities which transmit as well as generate and distribute, this will be another area of risk as the renewable industry grows. Municipal utilities will have to step up their game when it comes to assessing the costs and viability of renewable alternatives. They will not be immune to the pressures of adapting to small scale local generation.

CYBER SECURITY FRONT AND CENTER NOW

It has long been a  concern that a malicious hack could access the operational systems of many utilities. For a long time, the main focus was on the power industry. The worry has always been that a hack could result in blackouts of conceivably long durations. The Atlanta and Baltimore hacks did not interfere with operations at facilities like utilities and airports. 

Now the worst fears of the cyber security industry have come true with the recent hack of the water utility in Oldsmar, FL. In that event, hackers were able to take over a portion of operating systems and alter the chemical treatment process at the city’s waterworks. Someone had seized control of one employee’s computer  for several minutes and increased the level of sodium hydroxide—a caustic alkaline chemical used in small amounts to control the acidity of water. At the levels the hacker set, the amount of that chemical would have been increased 100 times above safe levels.  

Fortunately, the operators at the plant were able to stop the potential poisoning of the water supply to 14,000 residents. Unfortunately, we still remain at the mercy of local officials in terms of what the risk actually was or is, and what it might cost to prevent a recurrence. That remains the case with no clear standards for cyber security disclosure and a likelihood that such hacking efforts will be repeated. It is a risk that investors need to ask more questions about.

We think that the vulnerable utilities will be the smaller local utilities. They tend to be less than well funded given the small economic bases supporting them. This makes them more reliant on third party systems providers reflecting a less than adequate level of technical expertise. The risk is greater now that many of these systems are being monitored and operated remotely due to the pandemic. This requires remote access to utility systems which increases vulnerability. The intruder gained access to the plant through an employee who had installed TeamViewer, a widely used piece of software that allows someone to remotely view and control a computer.  

FOSSIL FUELS WORTH THE FIGHT?

A new study released by the Ohio River Valley Institute  has cast doubt on the value of reliance upon the gas extraction industry to local economies. Between 2008 and 2019, twenty-two old industrial and rural counties in Ohio, Pennsylvania, and West Virginia, which make up the Appalachian natural gas region, increased their contribution to US gross domestic product (GDP) by more than one-third. The direct economic benefits to those counties however, were nowhere near commensurate with their contribution to the national economy.

The 22 counties’ share of the nation’s personal income fell by 6.3%, from $2.62 for every $1,000 to just $2.46. Their share of jobs fell by 7.5%, from 2.8 in every 1,000 to 2.6. Their share of the nation’s population fell by 9.6%, from 3.2 for every 1,000 Americans to 2.9 for every thousand. In 2010, the American petroleum Institute projected that  nearly 44,000 new jobs would be created in West Virginia and 212,000 in Pennsylvania. Another study predicted the creation of an additional 200,000 jobs in Ohio.

Between 2008 and 2019 the number of jobs nationally increased by 10%, but in Ohio, Pennsylvania, and West Virginia, job growth was less than 4%. The 22 major gas-producing counties did even worse, with combined job growth of only 1.7%. Of the 22 major gas-producing Appalachian counties, only one met or exceeded national performance for all three measures of prosperity – income, jobs, and population. One other county outperformed the nation for two measures. Two counties outperformed the nation for a single measure. And 18 underperformed the nation for all three measures.

This sort of data should show the folly of reliance upon the fossil fuel industry. In states like Wyoming, the state is expected to embark on a legal effort to maintain fossil fuel production. This even as several coal mines will be closing this year in the state. That is not as a result of things like the Federal leasing ban on extraction. It’s a product of the market. Wyoming does not levy any income tax on either individuals or corporations. It relies on the easy money from mining and drilling. The risk is always that the product will run out, that markets change, and that progress continues.

Like any other concentration issue, reliance on one concentrated economic sector is always a source of credit risk.

PUERTO RICO DEBT PLAN

Puerto Rico’s Financial Oversight and Management Board (FOMB) announced that it reached an agreement in principle with several creditor groups to lower the commonwealth’s debt to “sustainable” levels. It requested a one-month extension of the deadline to file an amended plan of adjustment. The board said it reached the agreement with creditors holding about $7 billion in GO and Public Building Authority (PBA) bonds.

The new proposal would entail annual payments of $1.15 billion to $1.3 billion from the central government plus a Sales Tax Financing Corp. (Cofina) payment for 20 years, until 2041, and annual Cofina payments of $991 million between 2042 and 2058. The new proposal would represent a cut to the principal of the debt of between 55 percent and 58 percent, much lower than the one proposed in October, which was between 66 percent and 69 percent.

For the Puerto Rico Electric Power Authority (PREPA), an agreement between PREPA and the New York State Power Authority (NYPA) has been renewed. The agreement continues the role of NYPA in the utility’s recovery. NYPA helped inspect 50 energy substations following the earthquakes early last year and assisted in restoring power to hundreds of homes across the island. NYPA also helped prepare damage assessments and cost estimates to facilitate insurance claims.

NYPA will offer technical assistance to help stabilize Puerto Rico’s power grid and help prepare recommendations for rebuilding and hardening the island’s power system. NYPA will help PREPA strengthen its emergency preparedness and resiliency initiatives and will offer technical assistance to help stabilize Puerto Rico’s power grid and help prepare recommendations for rebuilding and hardening the island’s power system so that it is better able to withstand the types of natural disasters which have plagued the Commonwealth for years.

IBO BUDGET REVIEW

The New York City Independent Budget Office has released its preliminary review of Mayor Bill de Blasio’s budget proposal for FY 2022. The review is interesting not only for its view of the upcoming FY, but it also provides some view of the fiscal impact of the pandemic on the City.

IBO projects a fiscal year 2021 surplus of $3.62 billion. It estimates there will be $582 million in additional resources this year, offset by $324 million in unspecified labor savings, leaving $258 million more than the de Blasio Administration expects to be available to roll into 2022.  Total tax revenue is expected to fall by 1.9 percent from 2020 to 2021, the first year-to year drop since 2009. All of the city’s major tax sources are expected to shrink this year with the exception of the unincorporated business tax (5.4%) and the property tax (4.2%).

At the end of calendar year 2020, New York City had 557,000 fewer jobs than at the end of 2019, a decline of 11.9 percent. From calendar years 2015 through 2019, total employment increased by an average of 93,300 jobs each year. In 2020, the city lost 557,000 jobs, including 201,800 jobs in leisure and hospitality. In 2021 through 2025, IBO projects increases of 102,700 jobs per year on average, leaving city employment 43,000 jobs shy of its pre-pandemic peak. IBO projects additional resources of more than $1 billion in 2022, the estimated surplus is $490 million. For 2023 through 2025 IBO expects gaps of roughly $4.0 billion each year. In 2025, the number of jobs in the city will still be below the level at the end of 2019.

Property tax revenue is expected to fall by $1.0 billion (3.3%) from 2021 to 2022 brought on by major declines in assessments of commercial property, including large apartment buildings. The city’s financial plan assumes $1 billion in unspecified labor savings for each year from 2022 through 2025. It is still uncertain how the planned savings will be achieved in the upcoming fiscal years and what impact such actions could have for the provision of city services.

The review notes that the Biden Administration had authorized a 100% reimbursement of the city’s costs for combating the pandemic, as opposed to the typical 75%. This means the city will receive reimbursement for a total of $4.6 billion in Covid-related costs eligible for reimbursement from the Federal Emergency Management Agency—nearly $1.2 billion more than had been budgeted. So far, the Mayor has indicated he intends to use the newly available city funds to restore two cuts to the schools budget, leaving about $900 million unallocated.

The fiscal management issues are manageable but that is not meant to understate the current peril the city is in. The next mayor will have to complete dealing with the city economy, the transit capital needs, the capital needs of the housing agency, and the post-pandemic issues for the City’s public school students which the  Department of Education will face.

ANOTHER HOSPITAL CLOSES

The fact that its parent, Trinity Health, is one of the largest hospital systems in the country has not saved one Chicago hospital from the ongoing pressures in the healthcare space. Mercy Hospital and Medical Center was founded in 1852 and is Chicago’s first chartered teaching hospital. Nevertheless, the hospital was challenged in the current environment and its board had adopted a plan whereby a plan for Mercy that included the discontinuation of inpatient acute care services at Mercy and the wind-down of Mercy as a licensed full-service acute care hospital due to declining utilization rates.

The hope was that the service changes could be executed beginning at the end of May. The hospital required approval from the State of Illinois to make those changes. When the permission was not received, the path of bankruptcy and more immediate cessation  of activities became a strategy to eliminate the costs being covered by Trinity Health. For investors in Trinity Health (AA-) bonds, this is not a significant credit event. It cuts the losses (even after a $100 million plus capital investment since 2015) so the impact upon the overall Trinity credit from that standpoint is positive.

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